There are three simple time-tested rules in investing. But like a lot of things, they are in need of an update. This is the third post in a three-part series.
The first post in this series discussed the importance of diversification. Our Updated Rule #1 was: Diversify to the point of discomfort to control risk.
The second post in this series discussed the importance of keeping costs low. Our Updated Rule #2 was: Costs matter even more than you think.
Now for Rule #3: Buy low and sell high
This often-quoted maxim is quite possibly the worst investment advice ever given because it’s virtually impossible to do!
When exactly was the market low? Well, you might say it was quite low back in March 2009 after falling over 50%. But even then some pundits were calling for further declines, causing investors to hold off on buying. Unfortunately, there is no bell that rings when the market is at its lowest (signaling it is now time to buy) because no one knows how low it will go. Should you wait for the market to sink to the 2009 low again? If you do, you might miss out because it may never happen. Just ask those investors who sold in March 2009 when they are planning on buying again.
Market timing is a disappointing, if not impossible, game. So it’s time to discard the notion that investors should seek to buy low and sell high. Instead…
The investment maxim really should be “Buy when you have the money to invest, then add when prices are low and reduce when prices are high.” Since the financial markets generally go up, it’s best to invest when you have the money to do so. If you have money to invest today, what are you waiting for? Do you think you know which direction the financial markets will go? If you said “yes,” why aren’t you a billionaire already? Wouldn’t you have put those market-timing skills to good use by now? A better strategy is to be honest with ourselves and admit we cannot time the markets. No one can reliably do it.
Few investors or their advisors consistently practice “adding when low and reducing when high.” We’re all tempted by what is doing well and are fearful of what is doing poorly. That is just human nature. Most of us want to own more of what is doing well and shun the poor performers – which is more like “avoiding low and chasing high.” How much emerging market equity do you own today? Just a little? Then you or your advisor aren’t following Rule #3.
And, this is where low-cost, market cap index funds can go off track. If you think about it, a fund that tracks an index like the S&P 500 puts more and more of investors’ money into those companies that are doing the best (chasing high) and less in those companies that are doing poorly (avoiding low). This is the exact opposite of the third rule! And it contradicts the “invest in low cost, passively managed index funds” key takeaway of Rule #2.
But don’t despair! This is not an unsolvable problem. This short video explains one simple solution. Consider Fundamental Index Funds as they are designed to fix the potential problems with market-cap index funds. https://youtu.be/kHEgNmSzPsk
This leads us to Updated Rule #3: Invest like a kid in a candy store!
A kid with limited financial resources in a candy store can be quite smart. Since he likes candy, he always buys when he has the money. If the price of Jawbreakers and Pop Rocks doubles, he will look for something else to buy – shunning what has become more expensive. If the price of Smarties and Gummi Worms goes down, he will buy more than he normally would – adding more of what is cheap. He always seeks to optimize his candy portfolio. He is the perfect investor. If only candy could pay for college, set him up for retirement, and also be good for him!
For adults, investments are the vehicles that can pay for college, set you up for retirement, and do a lot of good over time.
These three updated investment rules will serve you well:
- Diversify to the point of discomfort to control risk
- Costs matter even more than you think
- Invest like a kid in a candy store!